The State and Local Tax Deduction Is Not a Subsidy

Should you ever be taxed on “income” that is not, in any meaningful sense, yours?

This is the fundamental question facing Congress in deciding whether to eliminate the deductibility of state income and local property taxes from federal taxable income, a policy change proposed by President Trump. Unfortunately, this question is unlikely to become part of the debate over tax reform. Instead, those who support the president focus on issues that are completely beside the point.

Some are arguing people living in higher tax states “benefit more” from the current system of state and local tax deductibility than people in low tax states. Those who point out this discrepancy often go on to claim this justifies the elimination of the deduction because these differentials between states actually constitute an “unfair subsidy” to those living in high tax states — New York, Connecticut, and California, for example — by those living in lower tax states like North Carolina, Texas, and New Hampshire.

But to call this deduction a subsidy of one set of taxpayers by another is putting the cart before the horse. The first question that needs to be answered is, is it appropriate, from either an ethical or economic efficiency perspective, to tax the revenue used to pay state and local taxes in the first place? If it is not, then any talk of subsidization of one group by another as a result of not taxing these revenues is irrelevant. Plus, in a tax setting, to subsidize means either to directly take income from some and transfer it to others or to benefit some categories of taxpayers by allowing them to operate under a different set of rules than all other taxpayers. The deductibility of property and sales taxes does not fit either of these categories.

Supporters of this change also argue the current system encourages higher taxes at the state and local levels. First of all, it’s not clear why this would justify taxing revenue that, from an ethical or economic perspective, shouldn’t be taxed in the first place. Once again, the cart is going before the horse. But what makes this a rather bizarre argument, particularly for conservatives, is that their remedy is to expose more of a person’s income to taxation at the federal level. They are, in fact, arguing for a transfer of taxing power from state and local governments to the federal government. So much for federalism.

So again, the question that goes begging is, should you be taxed on income that you are not allowed to take ownership of? As a question of morality or tax fairness, it is difficult to see how the answer could be yes. I don’t think anyone would claim that it is morally justified for an individual to be taxed on someone else’s income. But this is exactly the case with income that goes to paying state income taxes and property taxes. It is income we are forced to give up all rights to, with no enforceable promise of anything in return. Morally, as opposed to legally, this money is not our own, i.e., we have no choice about how it is allocated. Therefore, to not allow state income taxes to be deductible from federal taxes is the moral equivalent of taxing people on income that is someone else’s. In this case, it belongs to the state or local government.

One of Cordato's best observations here is that — even if one is okay with the idea of taxation in general — it is totally inappropriate to tax income that the taxpayer is being forced pay as taxes. Income that is taxed is never really income at all. It's just money the taxpayer must hand over involuntarily without being able to save it, spend it, or do anything other than watch it go straight out the door to the government. To call this money "income" is thus absurd. But this doesn't stop that advocates for the elimination of the deduction on those taxes. A good sampling of their demands for more taxes can be found in their response to my article on the topic[3]. They're so fired up about the imaginary "subsidy" that the deduction creates, they want to tax "income" that isn't income at all.